Class #22
International Financial Analysis
15.535 - Class #22
1
Next Steps for Projects
• Analyst Project Presentations
– In Class on May 12 and 14
– Same Format as previous presentations (should be no
longer than 8 minutes!)
– Due Diligence Presentations – (4-5 minutes in length) – Presentation Schedule is Posted in Announcements
• Due diligence on other team reports
– All teams must send their completed reports (Parts 1 and 2)
to their opposing due diligence teams.
– Due Diligence Teams should only evaluate PART 2 of the
analysis (ie the valuation using DCF and relative multiples
comparions.
15.535 - Class #22
2
International Financial Analysis and Valuation
• Differences in Accounting Across
Countries
– Outsider versus Insider Economies
• Legal Tradition and Law Enforcement
– Observed Differences in Accounting
Across Countries
• Differences in Opacity and Cost of
Capital Across Countries
15.535 - Class #22
3
Framework for Analyzing Accounting Across Countries
• Financial reports for firms from different
countries are often very different from
each other. WHY?
• See attached tables describing
properties of accounting earnings
across countries
– From Leuz, Nanda and Wysocki (2001)
15.535 - Class #22
4
Earnings Management Around the World (Leuz, Nanda, Wysocki, 2003)
Austria
28.3
South Korea
26.8
Italy
24.8
Taiwan
22.5
Switzerland
22.0
Singapore
21.6
Germany
21.5
Japan
20.5
Hong Kong
19.5
India
19.1
Spain
18.6
Indonesia
18.3
Thailand
18.3
Pakistan
17.8
Malaysia
14.8
France
13.5
Finland
12.0
U.K.
7.0
Sweden
6.8
Canada
5.3
Australia
4.8
15.535
Class
#22
U.S.
2.0
5
Accounting in Insider (Code-Law) Countries
• Insider Economies (Codified System)
– Legal system/accounting rules typically codified by
government ministries
– Close interplay between government & “major” constituents (large firms, banks, labor unions)
• Capital supplied by large banks and other big investors. – Governing boards of firms include banks, labor
unions and major suppliers/customers.
– Transactions rely less on public information in
financial reports.
15.535 - Class #22
6
Accounting in Insider Countries
• Insider Economies (Codified System)
– Continental European Origin
• Belgium, Denmark, France, Germany, Italy, Norway,
Spain, and Sweden.
– Japan: German commercial code & French accounting code adopted in (1800’s) • Result: – Public disclosure has smaller role in accounting
reports and rules.
• Dominance of private communication • Fewer publicly-traded companies in these countries /
Fewer small outside investors
15.535 - Class #22
7
Accounting in Outsider (Common-
Law) Countries
• Common Law System (Anglo-American)
– Evolves from bottom up (vs top down)
• Dispersed parties involved in “arms-length” transactions
– Final arbiter is often the court system:
– Financial reports try to present a “True & Fair”
picture of firm performance.
– Financial disclosures are more detailed.
– Generally former UK colonies
• UK, United States, Canada, Australia, New Zealand.
– Because of trend toward greater litigation in the
U.S., the financial reports of U.S. companies have
become far more conservative.
15.535 - Class #22
8
Implications of Poor Disclosure and “Opaque” Financial Reports
• What happens if outside investors cannot decipher a company’s financial report?
– Who bears the costs? What are the costs?
– PriceWaterhouse Coopers Survey of Corporate
Opacity:
• The O-Factor • Oi =average of (corruption, judicial and legal rights,
economic opacity, accounting and governance opacity,
regulatory opacity)
15.535 - Class #22
9
Some Differences in Accounting Across Countries
• Accounting Rules in many countries allow for
“Hidden Reserves”
– DEFINITION: An amount by which a firm has understated
Shareholders’ Equity in a given year. The understatement
arises from an undervaluation of assets or an overvaluation
of liabilities. By undervaluing the net assets on this year’s
balance sheet, the firm can overstate net income in the
future by disposing of the asset.
– Why is this allowed in some countries?
– What is this entry called under U.S. GAAP and law? 15.535 - Class #22
10
Big Differences in Accounting Even in “Similar” Countries
USA
United Kingdom
Since 1934, cannot
Revaluations allowed.
Asset
Revaluations revalue assets upwards Professional appraisers
(writedowns allowed)
assess value of assets
Accounting
for Goodwill
Purchased goodwill not
amortized (check for
impairment)
Purchased goodwill
either immediately write
off or amortize
LIFO for
Inventories
Allowed (must be same
for IRS report)
Not allowed
Intangible
Assets
Only purchased
intangibles recognized
All intangibles valued –
Use DCF or royalty
method (appraisers)
15.535 - Class #22
11
Differences in Accounting: Solutions
• Investors & analysts need information that is
consistent across companies – COMPARISON
• Diversity of accounting rules makes it difficult to
compare companies across countries
• Potential Solutions:
– Convenience Report: use local GAAP but print the report in
language of users
– Create 2 sets of reports under different standards (20-F
reconciliation)
– Use International Standards or adopt U.S. GAAP 15.535 - Class #22
12
Differences in Accounting: Solutions
• American Depository Receipts:
– An American Depositary Share ("ADS") is a U.S. dollar
denominated form of equity ownership in a non-U.S.
company.
– Represents the foreign shares of the company held on
deposit by a custodian bank in the company's home country
and carries the corporate and economic rights of the foreign
shares, subject to the terms specified on the ADR certificate.
– An American Depositary Receipt ("ADR") is a physical
certificate evidencing ownership in one or several ADSs. The
terms ADR and ADS are often used interchangeably.
– Each ADR is backed by a specific # or fraction of shares in
the non-U.S. company. The relationship between the # of
ADRs and the # for foreign shares is called the ADR ratio.
15.535 - Class #22
13
Types of ADRs
Expand Existing
Shareholder Base
Raising Capital with ADRs
Level I
Level II
Level III
public offer
Private
placement
GDR
(global)
Description
Unlisted in
the U.S.
Listed on
US
exchange
Shares
Placement
offered &
with
listed in US Institutions
Global
offering
Trading
OTC
Amex,
NYSE,
Nasdaq
Amex,
NYSE,
Nasdaq
U.S. and
non-U.S.
exchanges
U.S.
reporting
rules
Exempt
Form 20-F Form 20-F Exempt
reconcile to reconcile to
US GAAP
US GAAP
15.535 - Class #22
Private
Placement
Market
Varies
14
Daimler-Benz Case
• Daimler Benz filing with the U.S. SEC in
1993:
– As a condition for listing on the NYSE, Daimler
Benz had to meet the SEC’s requirements of
reconciling its accounts to US GAAP.
– Net income based on German GAAP was DM 615
million.
– Based on US GAAP, it had a loss of DM 1,839
million.
• Given the “embarrassingly” large difference, why did Daimler Benz accept to reveal this
information in the US GAAP reconciliation?
15.535 - Class #22
15
International Standards
• The International Accounting Standards
Committee (IASC) is an independent private
sector body. Objectives:
– Create uniform worldwide accounting standards
(Worldwide GAAP)
– Benefits:
• Shareholders, lenders, employees, suppliers &
customers can use one set of comparables and not have
to “translate” #’s across firms from different countries.
• Businesses have a uniform system for comparing
numbers of operations in different countries.
• Multinational companies will only have to prepare one set
of statements for its worldwide operations.
15.535 - Class #22
16
International Standards
• Limitations of International Accounting
Standards:
– Lack of consistent enforcement and application of
penalties across countries:
• Mexican firms with ADRs (Subject to SEC rules and
enforcement).
• Even in cases of fraud, SEC did not apply penalties • Question: Do firms bear the cost of misreporting financial
numbers?
– Other institutions have to change as well
15.535 - Class #22
17
Next Steps for Projects
• Analyst Project Presentations
– In Class on May 12 and 14
– Same Format as previous presentations (should be no
longer than 8 minutes!)
– Due Diligence Presentations – (4-5 minutes in length) – Presentation Schedule is Posted in Announcements
• Due diligence on other team reports
– All teams must send their completed reports (Parts 1 and 2)
to their opposing due diligence teams.
– Due Diligence Teams should only evaluate PART 2 of the
analysis (ie the valuation using DCF and relative multiples
comparions.
15.535 - Class #22
18